January 2009

jack-lambertIt is Super Bowl week for the National Football League.  It is also Super Bowl week for the market in my opinion.   In addition to a slew of earnings releases from market bellwethers in the pipeline, we will get economic news providing us some indication of just how bad 4Q08 was.   We know it was bad.   Retail data has been revealed, write downs have been announced and expectations have been slashed.   However, if it turns out to be worse than expected it will roil the markets and provide the television pundits plenty of fodder in which to claim that we are all going to go personally bankrupt, at least financially.  If we some how find a way to meet or exceed consensus estimates and market psychology does not pull us down much below the November 2008 lows, AND we end the week at 8000+, I expect that we will have established a bottom.  Small consolation, but you have to take what you can get right now.

Now to tie up a few loose ends:


Why are banks not lending?  This is the question my mother asks me on a weekly basis.  The good news, for me, is that she is not alone in asking me this question.  The bad news is that people don’t like my answer.   The reason, in my view, is that while TARP did neutralize the balance sheets of a handful of banks, it did nothing to remove the associated plutonium.   As such, when then portfolio companies of these lenders go Southern Hemisphere on their covenants, it sends the balance sheets back out of the alignment.  Further, as more companies are expected to experience financial distress, lending ratios will get further sideways.

In order to remedy this situation, the system is going to need a lot more money or a mechanism to move these bad assets of the balance sheets or to nationalize the banking industry.   This is probably the most difficult decisions to make, because there is no good answer.  Nationalizing the banking industry would basically put an end to the free market economy and market based capitalism as we know it.   Creating a liquidating asset management company like a Resolution Trust Corporation seems to make more sense on its face.  However, it creates a litany of questions that are vexing regarding pricing (face value, market to market) and who keeps gains and absorbs after the fact losses.  Clearly this would become a political issue resulting in the realization of the lowest cost denominator solution.  When is doubt print more money right?

That is FAScinating

Not really, unless you dig accounting issues, but I wanted to stick with the theme.

In November 2007, the Financial Accounting Standards (“FAS”) Board (“FASB”) issued Rule 157 (“FAS 157”).   FAS 157 dealt with the fair value measurement standard for assets whose value was, wait for it, hard to measure.  In developing FAS 157, FASB said it considered the need for increased consistency and comparability in fair-value measurements and for expanded disclosures about such measurements.  FAS 157 defines “fair value” as the price that the asset or liability would achieve in an orderly market transaction between informed participants at the measurement date.   I’ll spare you the rest of the accounting detail.

When FAS 157 was issued there was a litany of articles about how it was going to “rock the financial services industry to the core” or some such other derivative statement (most these “gloom and doomers” failed to recognize Goldman Sachs had been using mark-to-market accounting for years).   That didn’t quite happen, at least not at the time.  However, in light of the financial crisis many people are pointing at FAS 157 as the cause of unnecessary pain, as it has forced banks to market their assets to market in very troubling financial conditions.  Many of those who are complaining the loudest are private equity personalities, people who don’t like FAS 157 to begin with.  Historically, private equity firms would hold their investments at cost for at least a year unless a subsequent transaction justified marking it up or down.  They were negatively impacted, in their view, by FAS 157 as it would expose to the rest of the world, or at least to limited partners, their missteps.  Woe is me.

Well it turns out woe will be quite large.  This morning we learned that Thomas H. Lee partners wrote down $524 million worth of assets in order to comply with FAS 157.   With $8.1 billion under management, this is a healthy sum for a firm that is considered one of the oldest and most successful in the business.   I expect we are going to learn of significant write-downs across the industry.   On the plus side, this will give outsiders some insight into their valuation assumptions and view of the future, which will help inform companies as they consider their options for funding operations and achieving liquidity.


Okay, so I could not keep the streak going.

As expected, New Seasons Markets lost in their bid to not comply with the subpoena they received pursuant to the Federal Trade Commissions antitrust exploration regarding Whole Foods and Wild Oats.   However, New Seasons was able to come to an agreement with Whole Foods to limit its disclosure in certain areas so as to reduce the cost of compliance and limit the risk the company was taking in turning over sensitive information.   Through this process it also came to light that another company also sought a legal solution, but it is unclear who it was and what outcome their case has met.


eyeHappy new year to you all.  I hope you all had a safe and happy holiday season.  As the new year dawns, the general tendency is to fade in to prediction mode about what the upcoming year might hold on whatever front.  I’m not a great long range forecaster, and I have the equity portfolio that proves such.  Where I excel is in reading the next 3 – 5 moves in the game.   Summarizing the view from the trenches if you will.   I’m good at the middle game but far from being a grand master, able to see 10 – 12 moves forward.  However, what I am fairly confident in, is if I could warp the time space continuum, I would fast forward to 2010 and forget about 2009.   Unfortunately, I can’t do that, nor can I hold my tongue long enough to avoid making a few predictions, so here we go:

Hangover Not Cured

The economy is in the tank, and it is accelerating, not improving.  We just don’t know it yet because the Federal Reserve does not give us the numbers in a timely manner, but we should be able to infer it from the anemic retail and job reports, forecast slashing and weak earnings we are seeing.   ADP was nice enough to tell us that 693,000 jobs were lost in December, and the Federal Reserve was kind enough to make a series of ambiguous statements that they economy is in fact on life support, but without numbers people tend to shield their candle from the wind and tell themselves it will be alright.

It’s time to recognize that it is not alright and act accordingly.  Third quarter 2008 GDP contracted at an annual rate of 0.5% and politicians flocked to capital hill screaming bailout.  What will they say when they find out 4Q08 GDP shrank by over 5%+?  If this comes to be realized, and I think it will, I suspect this will be very damaging to consumer psychology.  If the consumer goes south, then we could push unprecedented levels on the contraction front.  People who are predicting a 2H09 recovery and talking about how the tea leaves are looking favorable for a cyclic rally to kickoff in April or May of this year appear to be living in an alternate reality.   Consumers psychology will not turn that quickly and their balance sheets will need to be rebuilt.  While I do not like to think or say it, I do not anticipate we will begin to see the light at the end of this recession tunnel until 2010, and that might be slightly optimistic.

The Dark Ages

As anticipated, transaction volume plummeted in 2008.   M&A volume was down a third for the year and 44% for 4Q08.  Domestic LBO volume was down 84% for the year, falling off a cliff in 4Q to $4.8 billion.   Global LBO volume was off 71%.  Almost all of the fourth quarter deal volume occurred in October, meaning that post-Lehman Brothers, all you could hear were crickets.   Wall Street should have taken the quarter off, to get a head start on taking 2009 off.

Part of the reason deal volume fell so precipitously was the lack of availability of debt capital.  Goldman Sachs and Morgan Stanley converted to commercial banks, not at their request, and banks then went in to “hoard capital” mode and have not come out of the turtle position.   Deal related debt fell to 4.9x EBITDA from the prior year period of 6.2x for deals with greater than $50 million of EBITDA and to 4.5x  from 5.6x for deals below this EBITDA threshold.

If there was a silver lining, price compression was not seen at the levels that were anticipated.  In fact deals with greater than $50 million in EBITDA cleared at a whopping 9.5x, the second highest observation ever recorded by S&P.  What this means is the quality bar was high and only the best deals got done.  With company toplines falling 20% – 40%, I expect prices to compress throughout 2009.

For the coming year transaction volume will be drive two factors burning strategic rationale or need.  Need will be driven not by buyers, but by sellers.  Properties will come to market as a result of having lost their debt facility, driven by shareholders that need liquidity and general financial distress.  Not a rosy picture.  I believe 1H2009 deal volume will be the worst ever with 1Q09 struggling to best 4Q08.   Smart companies with liquidity cushions will hunker down and ride this wave out, as opposed to going to market.  The best positioned will seek to snap up the best distressed properties for cents on the dollar and benefit as such at exit.  Further evidence of the “rich get richer” theory.

Ice is Not Fluid

Maybe the rate limiting factor to both economic improvement and improved transaction velocity will be achieving some viscosity in the debt capital markets.   Based on what we have seen TARP has done little if anything to meaningfully free of new capital to buy company side risk.   Fortune-500 companies continue to have unprecedented levels of cash on their balance sheets to insulate them from liquidity crises.  The cannot free up this capital until they can borrow.   Their bonds continue to yield mid-double digit returns in many cases.   The proposed Obama backed stimulus plan has done little to create a sense of stability in the market.  Lenders who told us to call them back in 1Q09 are now saying, call us in 2Q09, prompting us to coin the phrase “second quarter is the new first quarter”.

As some point someone is going to have to start lending at more cost effective levels than the long end of the yield curve is currently commanding or GDP will fall to unprecedented depths.   I do see this happening in 2009, the lending environment improving that is, either as a result of the government intervening by buying long term corporates, thereby driving yields down, or restricting the usage of funds proportioned in the bailout to certain activities including new originations.

Yes, 2009 will be bad.  Unprecedented levels of pain will be experienced by our nation and workforce.  There will be huge dislocation in the white collar industries, other than health care.  I hope for the best for all of us.  Live within your means, keep your senses about you, don’t follow faddish trading strategies when you do not understand the underlying market dynamics and find opportunities to celebrate the small victories in 2009.  For some, fortunes will be lost and for others made.  That who re-write the rules are more likely to fall into that later category.